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B. A., Adams State College, 1958 


submitted in "oartial fulfillment of the 

requirements for the degree 


School of Commerce 

Manhattan, Kansas 


Approved by: 


Ma jofi' Professor 










■ * 









Consolidated statements are accounting reports present- 
ing the financial position and results of operations for a 
group of affiliated companies. It is a generally accepted 
rule that if a company is more than 50 per cent ov;ned, it is 
consolidated into the results of the majority owner or parent 
company. It is also a generally accepted rule that a parent- 
subsidiary relationship exists whenever one company acquires 
a controlling interest in the voting stock of another company. 

A subsidiary is a separate enterprise with its own capital 
structure, earning capacity, and record-keeping system. The 
stockholders, creditors, and other interested parties should be 
aware of this fact. Consolidated statements are additional 
reports prepared as a supplement to the separate "legal entity" 
statements of the individual members of the economic family. 
In some respects, then , a consolidated statement is a legal 
fiction and consolidating procedures (adjustments, eliminations, 
worksheets, etc.) are not real, but are convenient operational 
devices. The earnings of the subsidiary are not the earnings 
of the parent and the assets of the subsidiary are not available 
to meet claims of creditor's of the parent. The Justification 
for consolidated statements is then the operating objectives 
of the affiliation. 

The elimination of intercompany transactions are treated 
in advanced accounting textbooks not as a single topic, but as 
individual components of different chapters and topics. They 

are not "oresented as a separate topic, but as elements of otner 
subject matter areas. Consolidated statements involve many pres- 
entation problems per se, v/hich in the ordinary course of study 
are difficult to comprehend. This situation tends to place less 
emphasis on the elimination of intercompany transactions than 
desired. However it is not the purpose of this report to stress 
these problems but rather to consider intercompany transactions 
in relation to consolidated income statements as one subject 
matter area and to report on the methods for their elimination. 


■'hen two or more corporations operate independently, they 
are viewed as separate legal entities. One corporation may gain 
control of other corporations by acquiring a majority of their 
stock. This control may be either direct or indirect. A direct 
control is acquired \.'hen a corporation ov^ns 50 per cent of the 
voting stock of another company. The company being controlled 
is iaiown as the subsidiary and the company doing the controlling 
is known as the parent company. If Company P owns controlling 
interest in the voting stock of Company A, and Company A owns 
controlling interest in the voting stock of Company B, Company P 
is said to have an indirect control of Company B. For example, 
if Company P owns 90 per cent of the voting stock of Company A, 
which in turn owns 90 per cent of the voting stock of Company B, 
then Company P is clearly able to elect a majority of the board 
of directors of Company A and, through Company A, to control the 
board of Company B. , 

when control is exercised over subsidiaries by a parent 
coiTOany it is desirable to show these companies as if they were 
operating as one entity. This is accoraplished by consolidating 
their financial activities into one set of statements/The con- 
solidated statements v/ill reflect the activities as if it were 
only one economic entity. 

In the absence of special circumstances, consolidated 
statements have become the common practice of stating the finan- 
cial position and results of operations for a r^roup of affiliated 
companies. The consolidated data should reflect the assumption 
that they represent a single business entity. 

The purpose of consolidated statements is to present, pri- 
marily for the benefit of the shareholders and creditors of the ■ 
parent company, the results of opeD.'-ations end the financial posi- 
tion of a parent company and its siibsidiaries essentially as if 
the group v;ere a single company with one or more branches or 
divisions." There is a presumption that consolidated statements 
are more meaningful for a fair presentation when one of the comoa- 
nies in the g^o^^P ^s^s a direct or indirect controlling financial 
interest in the other companies. 

The basic premise which underlies the preparation of consol- 
idated statements is that the affiliated comoanies are mana?:ed as 

Committee of ConceBts and Standards. "Consolidated Finan- 

cial Statements," The Accounting Review , April 19i?5» P» 19^. 

2 . 

Committee on Accounting Procedure. "Consolidated Finan 

St?tements." The Journal of Accountancy, Oct. 1959, p. 73. 

one economic entity and that financial statements similar to 
those customarily prepared for an accounting unit fairly present 
tlie financial position and results of operations of the consoli- 
dated economic entity. However the unique interdependence of 
affiliated companies sometimes introduces additional limitations, 
For example, since all tr;ansactions between affiliated companies 
may not be conducted at arm's length, the statements of the 
individual companies must be interpreted carefully and in con- 
junction with each other and with the consolidated statements. 
It is not possible to tell which companies are makinr< money from 
looking at consolidated statements, A consolidated net income 
figure may be misleading. It may be that the earnings are being 
contributed by a fev; companies £ind the balance in the group may 
be operating at a loss. There is no way of telling which compa- 
nies in the group are providing the earnings unless the separate 
statements are available, 

Y/ith the growth of interrelated companies, there has devel- 
oped a greater need for a better picture of the entire system, 
'The consolidated balance sheet and consolidated income statement 
have oeen created to fulfill this need. Since in such cases the 
interests of most of the parties concerned are identified prima- 
rily with the financial welfare of the entire system, the state- 
ments which v/ill disclose the financial position and earnings of 


•^ir'ercival p. Brundage . "Some Shortcomings in Consolidated 
Statements," Journal of Accountancy , Oct. 1950, -p, 290, 

fee system as a whole are indispensable. Consolidated statements 
disregard, or minimize, legal lines of cleavage and stress inana- 
:-:erial unity. In such reports the overlapping, intercompany 
accounts are canceled and a picture is drawn of the affiliation, 

the family of companies, in its over-all relation to the external 

■business co::iT.unity . 

In order to show the details of the manner in v/hich the 
consolidoted earnings of the affiliated corporation arose, as 
generally accepted by accountants, a consolidated income state- 
ment is prepared. All transactions between constituent coinpan.ies 
are eliminated. The remaining balances v;ill then represent the 
results of transactions with legal persons outside the group. 
The net r.rofit accruing to stockholders is then apportioned to 
controlling and minority interests. In the preparation of con- 
solidated statements, the. usual practice is to eliminate the 

estimated amount of intercompany gain which has not been finally 


consummated by transactions vjith parties outside the affiliation.' 

However, before the consolidated statements are prepared a uni- 
formity in records has to be established. This is necessary since 

Thomas Henry Sanders, Henry Rand Hatfield and Underhill 
Moore. Statement of Accounting principles , p. 101. 

''william A. Paton. Advanced Accounting , p. 573. 

^Sidney I. Simon. "Consolidated Statements and The Law." 
The ^\c counting Review, Oct. 1955 » p. 506. 


•^Sdward A. Kracke . "Consolidated Financial Statements." 

The Journal of Accountancy , Dec. 1938, p. 385. 

Che consolidated records will reflect the group of companies as 
one entity. The parent and subsidiary comoany do not necessarily 
have the sarae account titles and descriptions. The accounts 
•vvill have to be evaluated and classified according to their 

The eliminatign of the financial effect of intercorapany 
transactions, with the exception of intercomr/any profits in 
inventories and fixed assets when 100 per cent is eliminated 
from a subsidiary vendor, does not affect the computation and 
disclosure of the minority shareholders' interest in a subsid- 
iary company. In fact, the elimination of these items does not 
affect the net amount of the majority's interest because the 
items are reciprocal and cancel out. The elimination or cancel- 
ing out of these intercompany transactions simply prevents a 
padding of items in the consolidated statements. 

There are several intercompany transactions which must be 
considered in relations to the consolidated income statement. 
These intercompany transactions must be eliminated in order that 
the income statement will reflect the results of operation for 
the affiliation as one economic entity. 

Intercompany transactions and their relation to the consol- 
idated income statement will be discussed in this report. 

^Valter A. Holt. "A.ccounting Problems of Mergers and Con- 
solidations." N ♦ A . C . A . Bulletin, Sept. 195o, P« 136. 


Parent and subsidiary accounting is only one of many tools 
available to manag-eiaent . Consolidated statements minimize the 
separate "legal entity" statements and stress managerial unity 
through consolidation. The essential purpose of consolidated 
stateiT.ents is to display the income records and financial posi- 
tion of two or more affiliated companies as if they were one 
compt^ny. Consolidated statements are essential to management 
and investor, to provide a bird's-eye view of the activities of 
a going concern. Most of the difficulties involved in consoli- 
dated statements relate to a misconception of the purpose which 
they seek to accomplish. The theory behind these statements is 

that they should present an aggregate picture of an affiliation 

. , .^ . . , 10 

as II it v/ere one economic unit. 

The reasons for affiliation between parent and subsidiary 
will vary within the separate organizations. Companies which 
t)roduce raw materials may be acquired to assure a steady flow of 
such material at a favorable price . The subsidiary may be' ac- 
quired to enhance the parents position in a competitive field'. 
The rules of the Securities and Exchange Coramission as reflected 
in the Securities Act of 1955 represent another reason for having 

Paton, op. cit . , p. 751« 

Victor H. Stem|)f . "Consolidated Financial Statements." 
The Journal of Accountancy , Nov. 1956, PP. 56'^, 5 • 


consolidated statements. This act Qave the federal Trade Com- 
mission discretionary powers to call for consolidated statements 
in the regulation of new security issues. The rules of the 
I^Tew York Stock Exchange specify requirements similar to the 
Si'C regulations calling for the parent and each subsidiary or 
consolidated statements of the group. 

There are multiple reasons for acquisitions; hoviever in 
consolida.ted reports the intercompany accounts are eliminated 
and a picture is drawn of the aggregate enterprise in its rela- 
tions to the external business community. 


Interest, rents, fees, bonds, etc, must be recognized' by 

the individual companies when each is reco;-nized as sn independ- 
ent entity and must be included in its income statement. In 
pre^oaring a consolidated income statement for two or more 
affiliated companies these item? must be eliminauod. The con- 
solidated net income figure would not be affected by this elimi- 
nation because where one company v/ould show the amount e.s an 
income item the affiliate would show it as an expense. These 
items are eliminated in order to show the affiliated companies 
as one economic entity, and this is accomplished by eliminating 
the reciprocal accounts of the affiliates. All intercompany 
income should be eliminated in preparing a consolidated income 

Louis H. Rappaport. SEC Accounting Practice and proce- 
d ure , p. A-, 

stateiiient. If bonds or notes payable of affiliates sre held by 
Dsrties to tlie affiliation, tiie interest income of the credicor 
conpany from this source will be canceled against the correspond- 
ing interest charge of the debtor. Rental papments from one 
affiliate to another, royalties, and fees of any sort are like- 
wise set off against each other and eliminated from the income 

12 ' -" ■ . ■ ■ 
statement , ' . • 

Intercompany bond transactions are used to illustrate the 
typical elimination for intercompany interest, rents, fees, bonds, 
and other related transactions. 

Elimination of Intercompany Bond Transactions: 

If the parent Company (P) holds bonds of the Subsidiary 
Com-oany (S) the intercompany bond holdings should be eliminated. 
The intercompany interest income and interest expense should 
3lso be eliminated. The consolidation probleni is one of off- 
setting the, asset account of the bondholder against .the liabil- 
ity acco'ont of the issuer. The intercompany held bonds are 
essentially treasury bonds and from the standpoint of the con- 
solidated group should be treated as such. The following 
represent the a.pplicable entries: 

Bonds Payable - Company S $100,000 

Bonds of Company S - Company P ^100,000 

To eliminate intercompany bond holdings 

Rufus Wixon. Accountants Handbook , p. 25—^7. 


Interest Income - Company P (Creditor) ;j>570CO 

Interest Expense - Company S (Debtor) S5,000 

■To eliminate intercomipany interest income 
and interest expense 

The above illustration assumed that the bonds were acquired 
at par; therefore no unusual problem is encountered. V/hen bonds 
are not bought or sold at par the intercompany accounts may not 
be reciprocal. When this condition exists, reciprocity must be 
established before eliminating the asset account against the 
liability account. The following problem will illustrate the 
procedure for elimination when' bonds are reacquired from sources 
other than the affiliation. 

Elimination of 100 per cent 

Company P ov/ns 90 per cent of the stock of Company S. 
Company S has outstanding $100,000 of bonds with an unamortized 
premium of S3, 000. Company P purchases :-|?50,000 of the bonds 
from outsiders for fj^9,000 or at a i?l,000 discount. The gain 
on reacquisition of the bonds may be computed as follows: 

Total Outstanding Reacquired 
Maturity value $100,000 ^50,000 S50,000 
Premium $,000 1,^00 1,^00 

Book value $103,000 S31,300 $51,500 

Cost of bonds 

reacquired by P 49,000 

Gain on reacquisition $ -^,500 


The worksheet elimination assumes that the gain v/as made 
by Company P and that the $2,500 fsain accrues to Gomoany P 
stockholders. Ttie elimination v;ould he as follows: 

Premium on Bonds Payable ffl,500 

Bonds of Company S 1,000 

Gain from Heacquisition of 

Bonds - Company P 1?2,500 

•To reflect sain from reacquisition 


The consolidated v/orking paper should reflect the entries 
as follov/s: 

Co. Co. Adjustment & Consolidated 
P S ' Elimination Financial 
Debits Dr. Cr . Statement 

Bonds of S 1549,000 5U,000 A ;$50,000 


Bonds Payable $100,000 100,000 

Premium on 

Bonds 5,000 1,500A 

P.etained Earnings: 

Co. P ^' $2,500 A 

Assuming that the 100 per cent elimination is to be snared 
between, the consolidated retained earnings and a minority interest. 
The minority interest being ZO per cent. The elimination would 
be as in the preceding illustration except a minority interest 
of 20 per cent should be reflected as shovm in the following entry. 

Premium on Bonds Payable $1,500 

Bonds of Company S 1,000 

Retained Earnings - Company P "^2,000 

Retained Earnings - Minority Interest 50O 

To reflect gain to Co. P and also in 
minority earnings. 



Bad debt amounts arising from intercompany debts should be 
eliminated. If the charges for bad debts expense and the cor- 
resDonding allowance for ^oncollectibles are not scrutinized 
carefully to determine the amount arising from intercompany 
debts, the consolidated profit will be understated due to tliQ 
lack of the elimination of the expense and the allowance for 
uncollectibles. The allowance account in. the balance sheet 
would also be overstated if the amount allocable to the inter- 
company allowance is not removed. Since the debtor-creditor 
relationship between affiliates is eliminated in total in a 
bonsolidated balance sheet, a charge for bad debts in an income 
statement has no meaning for the group viewed as a unit. Whether 
individual affiliates pay or do not pay intercompany debts has 
no effect on consolidated income or net assets. Although the 
use of an allov/ance for uncollectible intercompany accounts is 
undesirable, v/hen such a provision is found an adjustment is 
made on the consolidated working papers debiting the allov^/ance 
for uncollectibles and crediting bad debt expense of the creditor 
company. The working paper entry would appear as follows: 

Allowance for Uncollectibles -.,Co. P iJ150 

Bad Debt Expense - Creditor Co. S S150 

To eliminate intercompany allov;ance for 
uncollectibles from consolidation' 

-"•^ Ibid . , p. 25-48. 



What should be done with the intercompany markup in assets 

which remain on hand by the purchasing affiliate at year end? 

The American Accounting Association in its Accounting and 

Reporting Standards for Corporat e Financial Statements recommend 

the following: 

In the consolidated financial statements, no gain 
or loss should be recognized as the result of transactions 
among affiliates. From a combined point of view, these 
transactions result merely in a shift of assets from one 
department or branch to another department or branch of 
the same entity. Therefore: 

1. The elimination of intercompany markups in assets 
should be complete, irrespective of the presence or 
absence of an' outside (minority) interest. This 
procedure is necessary to insure a cost basis which, 
properly should not be affected by the pattern of 
share ownership. 

2. The amount of intercompany markup to be eliminated is 
the intercompany gross margin reduced by any inven- 
toriable costs incurred in the movement of the goods 
from one affiliate to another. 

5. The intercompany gain to be eliminated from assets 
logically is applied in consolidation as a reduction 
of the income or retained earnings of the affiliates 
that have recorded the gain. If any such affiliate 
is a subsidiary with a minority interest, the per 
share equity of that interest is thus reduced, in 
the consolidated statements, in the same manner and 
in the same proportionate amount as the controlling 
interest. The practice of reflecting a minority 
interest's share of unrealized intercompany profit 
as if realized, while widely accepted, conflicts 
with the underlying purpose of consolidated finan- 
cial statements as herein contemplated, namely, to 
reflect the activities of a group of companies as 
though they constituted a single unit. 


American Accounting Association. Accounting and Reporting 

Standards for Corporate Financial St atements and Preceding 

Statements an.d Supplements , p. 45. 


In the preceding quotation, the American Accounting Associ- 
ation describes the way intercompany profits in assets should be 
handled. There are several methods of handling intercompany 
profits in assets v/hich will be considered within each inter- 
company transfer listed below, 


If the inventories remain within the affiliated group no 
profit has been realized as evidenced by a sale to outsiders, 

consequently we must eliminate the intercompany markup or profit . 

included in the reports of the affiliated companies. '^ The 

elimination of intercompany sales has the effect of leaving as 
a remainder a consolidated sales figure which represents the 
results of transactions with outsiders. Since an intercompany 
sale will show as a purchase on the vendee's books, the cancel- 
lation can usually be performed without difficulty. An exam- 
ination of the records of the constituent companies is necessary 
in order to make sure that all intercompany transactions have 
been completely recorded. By eliminating the intercompany sales 
with purchases , the whole transaction is erased as though it had 
never occured. The intercompany profit along with the sale, 
included in the sales figure, is eliminated. The problem arises 
when some of the intercompany merchandise remains on the books of 
the vendee company at year-end. The profit included in this year- 


-^Maurice Moonitz. "The Entity Approach to Consolidated 

Statements." The Accountin.p: Review , July 1942, pp. 238,9. 


end inventory must also be eliminated because it has not been 
realized in the consolidation. The elimination of the unreal- 
ized profit in the beginning and ending inventories result in 
a consolidated cost of goods sold which includes only the cost 
of goods sold to outsiders. Failure to eliminate the unreal- 
ized profit from the beginning inventory will overstate the 
cost of goods sold and understate consolidated net income. If 
the unrealized profit remaining in the ending inventory is not 
eliminated the consolidated cost of goods sold will be under- 
stated and profits overstated. Therefore, the computation of 
consolidated cost of goods sold and of consolidated gross profit 
is closely related to the problem of inventory valuation. The 
consolidated cost of goods sold is computed by taking the com- 
bined cost as shown by the books of the constituent companies 
less intercompany purchases plus or minus adjustments of inven- 
tory figures. The consolidated v/orking paper should reflect the 
following entries w^hen there is intercompany profit in merchan- 
dise in the beginning and ending inventories: 

Cost of Goods Sold - ' . <5lO,000 

Inventory o>10,000 

To eliminate Intercompany profit in . ^ 

ending inventory 

Retained Earnings .i?10,000 

Cost of Goods Sold ^10,000 

To eliminate intercompany profits in 
beginning inventory 

Kracke, op. cit . , p. 586, 


Tiiere are other situations that might arise '.'ith inter- 
com-nany sales of merchandise. One situation occurs with raarket 
write-downs arid intercojnpany profit deductions. If the inven- 
tory valuation of merchandise acquired from an affiliated 
company has been reduced from cost to market and the amount of 
the reduction is the same or greater than the reduction that 
would have been Laade for intercompany x^rofit then no further 
reduction in the inventory valuation need be made. If the 
market write-down was less than the intercompany profit a work- 
ing paper adjustment is made only for the intercompany profit 
not eliminated. A.n other situation occurs when there are inter- 
company sales at a loss. Jf consistency is to be maintained 
v;ith the elimihation of intercompany profits, it follows that 
the inventories should be increased by. the amount of intercompany 

n 17 

loss. ' 


When fixed assets are transferred between affiliated com- 
panies, there arises a need to eliminate, on the consolidated 
working peepers, any profit that the vendor has recorded on his 
ledger and any of this profit that has found its way into the 
consolidated retained earnings which is considered to be unreal- 


'Commxttee on Accounting Procedure. "Consolidated Finan- 
cial Statements." Accounting Research Bulletin Ko. 51, pp. 4^,5. 


There are two methods of eliminating intercompany profits 
on fixed assets. The first method is the elimination of one- 
hundred per cent of the vendor's profit. This method assumes 
that the cost to the selling company is the cost to the con- 
solidation. In the year in which a fixed asset is bought and 
sold within the affiliation the simplest procedure is to reverse 
on the working papers the effect of the sale in terms of the 
selling company's accounts and to credit the consolidated fixed 
asset account for the unrealized profit margin. The entry on 
the working paper would be as follows: 

Gain on Sale of Assets - Co. S. (Selling) $2,000 

Fixed Asset Accoimt - Co. P (Purchasing) 5>2,000 
To eliminate intercompany profit in fixed assets 

In the above hjmothetical entry the asset acquired by 
Company P from Company S is reduced to cost and the profit 
reported by Company S is eliminated. 

The elimination of intercompany profit in' assets can be 
further complicated v;hen assets subject to depreciation or amor- 
tization are bought and sold between parent and subsidiary or 
betv/een one subsidiary to another. Assets acquired from another 
company in the group may reflect realized profit for the selling 
company; therefore an adjustment is required to eliminate the 
profit element. Assume that an asset is sold for S50,000 which 
includes a profit of ^^10,000 or 20 per cent intercompany profits, 
The asset has an estimated useful life of 10 years and is being 
depreciated on a straight-line basis. Three situations will be 


considered: (1) Consolidation in the year of sale, (2) the 
consolidation one year after sale, and (3) the consolidation 
tv>'o years after sale. 

Sale "by Parent to Subsidiary 

1 , Consolidation immediately after sale . 

Gain on Sale of Asset - Co. P ^10,000 

Asset Account - Co. S. .^10,000 

1 o 

To eliminate intercompany profits. 

2. Consolidation one year after sale . 

Retained Earnings - Co. P S10,000 
Allowance for Depreciation - Co. P 1,000 

Depreciation Expense - Co. S . $ 1,000 

Asset Account - Co. S 10,000 


To eliminate intercompany proiit. 

3' Consolidation tv;o Years after sale. 

Retained Earnings - Co. P $ 9,000 
. Allowance for Depreciation - Co. S 2,000 

Depreciation Expense - Co. P ' $ 1,000 
Asset Account - Co. S 10,000 

To eliminate intercompany profit 

Each year on the consolidated v/orking papers, depreciation 
expense must "be credited for the difference , and the proper 
allov;ance fro depreciation must be debited an equal amount. 

1 Pi 

The percentage ownership of the parent is not considered. 
The adjustment is made for the full amount of the profit. 


-^The adjustment removes the 20 per cent profit element. 


Each year the carrjinj: value of the fixea assets nust be ad- 
justed iron the net figure v./nich equals cost to the vendor 
less accumulated depreciation thereon. Each. year, since the 
•vvorking ;oapers are not automatically continuous, fixed assets 
must be credited on the working papers for the initial unreal- 
ised r^rofit aarrin, the allowance for de-c^re elation must be 
debited for the difference between depreciation on cost and 
per the vendee's books accumulated to the first of the year, 
8nd consolidated retain .u earnings must be debited for the 

balsjice. The profit element in the year of sale must also be 

n • • -- ^ 20 

The second metnpd assiuaes that the cost to the consoli- 
dated entity is the cost to the vendor plus the profit of the 
vendor applicable to its minority. Only the parent company's 
share of the intercompejiy profit is eliminated from consoli- 
dated profits. This is true because only the parent co.:ipany's 
share of the reported interco.apany rjrofit is carried to the 
consolidated profits and retained earnings. In follovving years 
the annual depreciation charge to the consolidated entity is 
based upon the sxim of the cost to the vendor plus the profit 
applicable to the vendor's minority interest." 

The eliminating entry for the profit or loss must be 


Ivioonitz, £0. cit . , p. 259. 

Stempf, 0T>. cit . , pp. 568,9. 


reduced by depreciation since the date of transfer and any 
excess depreciation over that normally taken by the transferor 
must be reckoned v.dth and eliminated every year. During the 
service life of the fixed asset, the vendee will usually include 
in its income statement a charge for depreciation expense based 
on the purchas© priot. 3inoe an int©roomnany profit was in- 
eluded in the purchase price, the depreciation figure will be 
too hish for use in a consolidated statement. Consequently, 
depreciation will have to be recomputed on a basis of cost to 
the entire group and an entry made debiting allowance for 
depreciation and crediting depreciation expense. Thus, when 
fixed assets are transferred between comoanies at a profit, the 
depreciation expense, from the consolidation viewpoint, will 
have to be reduced; and if transferred at a loss, will have to 
be increased, since for consolidation purposes depreciation is 
based on cost to the original purchaser.'' 

In the writer's opinion intercompany sales between affili- 
ated companies in reality are intercompany transfers which are 
made for the convenience of the consolidation. It follows that 
the practice of transferring depreciable property between the 
group must be carefully studied and reviewed in the future. 

'^^. J. Erp. "Preparing Consolidated Statements for 
Majaagement . " Controller , Aug. 1955? P» 553. 


Vixon, OT). cit. , p. 25-'^G'. 


This is primarily because of the Revenue Act oi 1962 v/hich 
allows a 7 per cent investment credit for eligible property, 
or "Section 58 property," as defined imder Section ^S (b) of 
the Internal Revenue Code of 195^. This investment credit was 

p-ranted to help in the acceleration of the economy through 
encouragement of investments in productive facilities. The 7 
per cent investment credit in, "Section 58 property," nev. and 

to a limited extent in used depreciable property excluding 

buildings may be subtracted from the tax liability. 

The problem is that intercompany transfers may result in 
the loss of the investment credit just as if the property were 
sold or otherwise disposed. The credit lost may be all or a 
portion because Section 48 (c) of the Internal Revenue Code 
makes it clear that the property transferred to the acquiring 
corporation does not qualify as used property iinder "Section 
58' property," The property must be purchased as defined in 
Section 179 (a-)(2). This section specifically excludes property 
8cq.uired from within the affiliation. The problem of inter- 
company transfers of "Section 58 property" will affect groups 
where there is a common parent corporation. Where there is a 
group of brother-sister relationship, in an early transfer be- 
tween them a loss of credit to the selling corporation may result. 


Internal Revenue Service. "Special Supplement, 1965 

Federal Tax Course, The Revenue Act of 1962, pp. 5-12. 


however the acquiring corporation would be entitled to the 
credit based on "Used Section 58 property." Used property is 
subject to the limitation of 1150,000 per year. 

Section 43 (b)(2) requires that "Section 38 property" 
begin in use with the taxpayer in order to qualify. The 
company purchasing "Section 58 property" must use it. However 
if the company purchasing the property does not use it, but 
right after acquisition transfers it to some other co^ipany v;ith- 
in the group, it will be mandatory to maintain accurate records 
to indicate that the purchasing company was actually a purchasing 
agent and that it did not use the property or that the property 
was new to the corporation for whom it v;as purchased. The trans- 
fer of Section 58 property v/ithin the affiliation must follow a 
consistent policy as specified in Section 48 (b)(2) or risk the 
loss of the investment credit applicable to that property trans- 
ferred. Adequate records must be maintained to substantiate the 

special arrangements between the companies in the affiliation. 


Intercompany dividends are excluded from the consolidated 
income statement. The primary reason for the exclusion is that 
dividends represent neither income to the recipient nor an 
expense to the corporation making the payment. Dividends repre- 
sent a distribution of profits and are not themselves an ele- 

"" .Vallace M. Jensen. "Tax Clinic", The Journal of 
j^ccountancy , March 1963, pp. 77,78. 


ment in profit. Consequently duplication of income is avoided 
by eliminating intercompany dividends upon consolidation. A 
further reason for excludine; dividends is that they are not 
based exclusively on the profits of the period in which they 
are declared or paid. Dividend declarations are based, legally, 
on the existence of certain types of surplus, usually retained 
earnings, which may have arisen as the result of transactions 
occuring in :>rior periods. Therefore, even if it is assumed 
that dividends come out of the profits most recently earned, 
they often exceed the income of the current period. To avoid 
this situation, only the underlying transactions of subsidiaries 
which result in a profit available for dividends are shown in a 
consolidated income statement.- Dividends received from related 
companies which are not consolidated ate included in the consoli- 
dated income statement if the recipient carries the investment 
account at cost. If the recipient's investment account is ad- 
justed for changes in the book value of the underlying equity, 
then a dividend is credited to the investment accoimt and appears 
neither in the income statement of the recipient nor in the con- 


solidated income , statement . ~ 


The consolidated net income figure which is apportioned be- 
tween the controlling and minority interest is arrived at through 

^■/ixon, £0. cit . , p. ^3-50« 


the elimination of intercompany income and expense iteias and 
intercompany profits." The amount of consolidatea income -co 
allocated to the minority interest will depend on the methods 
used in eliminating intercompany profits. The American Ac- 
counting Association in its Survey of Consolidated Financial 
Statement Practices found that: 

Of the 60 com-oanies which had minority interests, 
53 per cent reported that they had the -oroblem of inter- 
com'osjiy profits m;->de hj the 'oarent company. Thirty 
eliminated the profit entirely from the consolida>:3d 
earned surplus, tv;0 eliminated only the portiv^n cor- 
responding to the parent company's interest in the sub- 
sidiary, and one, a meat packer, made no elimination 
because the inventories were valued at selling price 
less allowsuice for selling and distribution expenses. 

Nineteen companies indicated that intercompany 
profit had been made by subsidiary companies. Sixteen 
eliminated the entire amount from the consolidated 
earned surplus, one eliminated only the parent com.rjany's 
share, and two made a complete elimination but divided 
the amount between, ^consolidated earned surplus and the 
minority interest."^ 

V.hen the controlling interest's equity in intercorapany 
■nrofits is elim.inated, the minority interest is credited with 
its share of the subsidiary's profit, unadjusted for interr 
company lorofits. The remainder is then allocated to the 
controlling interest, ivhen intercompany profit is eliminated 
a minority's interest in earnings is equal to its proportion 
of the net income of the individual company after adjustment 

'Simon, oi^. cit . , pp. 512,5- 

American Institute of Accountants, Survey of . Consolidated 
Fin a ncial Statement Practices , p. 17. 


for intercoinpojiy profits. ?or example subsidiaries, Corapt.ny S 
and Compsjiy T had net income of ;$20,000 and $50,000 respectively. 
These figures include a minority interest of 10 per cent in each 
subsidiary. The figures also represent intercompany profits of 
$1,000 and S2,000 respectively. The allocation s-iould be made 
as follows: 

Intercompany profits 

Reported profit of Go. 3 5^20,000 

Reported profit of Co. T 50,000 

Total . S50,000 

Controlling Co's equity in intercompany profits 

Co. S = ^?1,000 X 90% $ 900 

, Co. T = 2,000 X 3(y/o 1,800 (:^,700) 


Minority interest in consolidated net profit 

Co. S = 10?^ of S20,000 $2,000 

Co. T = 10;^ of 50,000 " 5,000 (5,000) 

Controlling interest in consolid&ted 

Net profit^ h42,500 

Dr. Lloonitz -oresents an argument against the customary 
method of computing minority interest for consolidated state- 
ments if there are mutual holdings of capital stock. His con- 
tention is that stocks of a corporation held by its subsidiary 
should be treated as treasury stock and be deprived of its voting 
nower as v^ell as the right to share in dividends. Dr. Moonitz 
computation of minority interests is based on the assumption that 
shares of the parent company held by the subsidiary and an 


e'-iuivalent amount of stock of the subsidiary iield by the parent 

corporation do not share in dividends. 

The v/riter prefers the customary method as presented because 
the minority stockholders investment in a parent company is an 
investment of a part of their company net worth and could not 
be eliminated because the parent company had as large, or larger, 
investment in their company. 


Three methods of eliminating intercompany profits will be 
considered. They are the cost method, the entity method and the 
equity method. 

In the cost method the underlying assumption is that the ■ 
assets transferred should be stated, for balance sheet purpose, 
in terms of the original cost to the first purchaser. In other 
v/ords, the elimination entry on the working papers v/ill not only 
accomplish the removal of unrealized profit, but will permit the 
asset account to be valued at cost for the balance sheet. 

The entity method as advocated by Maurice Moonitz, Ph.D. 
recommends, in effect, that neither the parent company nor the 
subsidiary can realize a profit or loss on an intercompany trans- 
action. Under this method all of the effects on all the ledgers 
of all the intercompany transactions v^hich contain unrealized 
profits must be reversed. If the parent company made a sale to 


""^Maurice Hoonitz. "Mutual Stockholdings in Consolidated 

Statements." The Journal of Accountancy, Oct. 1959, Pp. 227-35 • 

• . , . 27 

a subsidiary at a profit, then for consolidated purposes, under 
the entity method, the unrealized profit v/ould have to be removed 
from the inventory account and also 'from the parent's retained 
earnings. If the subsidiary made a sale to the parent company 
and thereby realized a profit on its ledger, the profit increment 
must be eliminated from the inventory and from the subsidiary's 

earnings, and also the percentage of this profit that the parent 

company has recorded in its retained earnings must be eliminated. 

For example, if the parent company h:;s an 80 per cent interest in 

a subsidiary, it must eliminate 80 per cent of the unrealized 

TDroiit v;hich it has nicked up as realized from the subsidiary. 

The simplest procedure to accomplish this on the working papers 

is to reverse the effect of the intercompany profit from both the 

vendor's and vendee's point of viev/. 

Consolidated statements are traditionally parent company 

statements, with minority interests being virtually ignored 

except as an amount necessary to make the balance sheet balance. 

Those advocating the use of the "entity" theory recommend that 

the equity section of the balance sheet include the minority 
interest as "co-owners" of the enterprise. 

The equity method advocates that all effects of an inter- 
coii-oany transaction on consolidated retained earnings must be 

eliminated. When only the parent comoany's share of the inter- 

coa-pany profit is eliminated from consolidated profits, the share 


■^ Hoonitz, "Entity Approach," pp. 236-'4-2. 


applicsble to the minority interest in tne vendor is consiaerea 
as earned by the minority. Under this method the consolidated 
working papers will acouall.y recognize or realize part of the 
interco.;ipany profit. Therefore, the consolidated profit arising 
from intercompany transactions will tend to be less than the 
profit recorded on the parent and subsidiary ledgers, but in an 
amount equal to the elimination. When this method is used, the • 
inventory which is carried to the bbl- nee sheet is overstated, by 
the amount of the profit not removed and recognized as realized. 

V.hich of these metnods is employed is a matter of the 
accountant's ov-n discretion. If it is generally accepted that 
there is no increase in value when goods are transferred from 
one affiliate to the other, then it would seem logical on con- 
solidations to eliminate the entire intercompany profit regard- 
less of minority interests. This is tne usual case, but there 

is by no means unanimity of opinion v/here it comes to allocating 

the elimination to the proprietary interests.-^ 

The American Institute of Certified Public Accountants 

advocate the use ■ of the entity method for intercompany profit 

eliminations. The Committee on Accounting procedure set forth 

the following viev/: 

In the preparation of consolidated statements, inter- 
company balances and transactions should be eliminated. 
This includes intercom'oany open account balances, security 
holdings, sales and purchases, interest, dividends, etc. 
As consolidated statements are based on the assumption 
that they represent the financial position and operating 
results of a single business enterprise, such statements 


"^ John Peoples. "Preparation of Consolidated Statements. . ." 

The Journal of Accountancy, Aug. 1957 » p. 5^. 


should not include gain or loss on transactions among 
the conroanies in the group. Accordingly, an;/ intercorarjany 
profit or loss on assets remaining within the group should 
be eliminated; the concept usually applies for this purpose 
is gross profit or loss. However, in the regulated industry 
where e parent or subsidiary manufactures or constructs 
facilities for other companies in the consolidated group, 
the foregoing is not intended to require the elimination 
of intercompany profit to the extent that such profit is 
substantially equivalent to a reasonable return on invest- 
ment ordinarily capitalized in accordance with the estab- 
lished practice of the industry. 

The Research Department of the American Institute of 
Certified Public Accountants conducted a survey to determine the 
opinion of accoxmtants on the subject of elimination of inter- 
company profits. The accountants were asked to indicate whether 
they thought the eliminations should cover only the controlling 
interest equity in intercompany profits or should include the 
full amount. Those who replied were evenly divided in their 
reactions to this question. Several advocated eliminating the 
full amount of intercompany profits, apparently on the grounds 
that, as a practical matter, refinement is not necessary. One 
accountant favored elimination of the full amoimt of inter- 
company profits with the portion applicable to the minority 
purposes; others would eliminate the full amount, but in com- 
puting the minority interest would not reduce it to the extent 
of its share in intercompany profits. 

Several accountants asserted that consolidated earnings and 


-^ Committee on Accounting procedure. "Consolidated Finan- 
cial Statements . " Accounting Research and Terminology Bulletins 
1961, pp. ^2,5. 


corsolidated inventories should be reduced only by the portion 
of unrealized intercompany profits attributable to the con- 
trolling interest. The entire minority interest in the sub- 
sidiary's profit should then be deducted from consolidated 
-■^rofits in arriving at consolidated profits applicable to the 
controllins interest. To take out the entire unrealized inter- 
company profit ejid the minority's share of the subsidiary's 
profit, it v/as argued, would reduce the remaining consolidated 
net profit below that amount properly applicable to the con- 
trolling interest. Follov^ing this treatment, some portion of 
unrealized profit v;ould remain in consolidated inventories, but 
this is as it should be since it represents cost to the consoli- 

The elimination in connection v/ith the cons-xidated finan- 
cial st3.tements present several additional matters for particular 
attention. The elimination in connection to intercompany sales 
••=nd intercompany cost of sales exclusive of the adjust:'.ient of 
■cost of sales for unrealized profit in inventories follow one 
or tv;o orocedures. In the first, sales are eliminated from the 
selling affiliate and purchases by the purchasing company are 
removed from the cost of sales. This method results in a mutual 
cancellation and there is no difference in net income. In the 
second, total intercompany sales are eliminated from sales, but 
instead of a similar elimination of purchases, it is the related 

Research Department, American Institute of Certified public 
Accountants. "Pome Problems Regarding Consolidated and Parent Com- 
pany Statements." The Journal of Accountancy, Nov. 1955, pp. 57^,5. 


amount of cost of sales as computed by the selling unit v;hich. 
is removed from the total cost of sales. This results in a 
diffarence representing the operating results as a profit or 
loss, depending on the circumstances. Separs-te adjustments 
are made in this case showing tne difference in the consoli- 
dated report. The second metliod is used to show specific 
disclosure of the profit and loss attrihutable to certain 
activities of the business. This difference related to the 
entire amount of intercompany transactions during the period 
involved, inclusive of the profit or loss realized on the 
product finally included in consolidated sales to outsiders 
as v/ell as products still on hand in the inventory of the 
purchasing affiliate. 

The profit element in the ending inventories tor^ether with 
the effect of the related adjustment attaching to the opening 
inventories require adjustment in each of the two cases. These 
adjustments will affect retained earnings for the period. Aside 
from such consolidating adjustment for unrealized intercompany 
iDrofits in inventories and in some cases iproperty, other elimi- 
nations do not ordinarily affect the retained earnings for tne 
period. There are excemptions in the case of intercompany 
payables where the selling company has not recorded the income 
because it has not been earned. 

From the many comments and reasons which were received from 
the survey in addition to other information available, it is 

-^ Kracke, ot. cit . , p. 386. 


arroarent that tjiere is no one x-^ay to eliminate inter comoany 
Tirofit. As long as the reason underlying the raetnod is sound, 
it can be deemed acceptable in consolidating, 


For every corporation, regardless of its relation to 
other companies, there should be raaintained a distinct system 
of accounts; and for every corporation, separate financial 
statements should be periodically prepared. Such accounts and 
statements, however, may not alsways be adequate to meet the 
reauirenents of managers and owners at the primary control 
level of a group of affiliated enterprises. Wherever there is 
an area of doniinating ownership and administration there is 
likely to be need for showing operating performance . and finan- 
cial position for the group as a whole.' Consolidated statements 
aj;e designed to take care of tiiis need. 

•The essential purpose of consolidated statements is to • 
display the income record and financial position of two or more 
associated companies as if they represented a single enterprise. 
Consolidated statements minimize the separate "legal entity" 
and stress managerial unity. In such reports, the overlapping, 
intercompany accounts are canceled, and a picture is drawn of 
the affiliation in its over-all relation to the external business 

The stockholders, creditors and other interested parties 
should understand the limitations of consolidated statements, 
particularly in viev/ of the rapid acquisition of subsidiaries 


and tlie indiscriminate use of such statements. The fact that a 
consolidated report does not reflect conditions of any distinct 
legal entity is also emphasized. Consolidated statements should 
be viewed as a supplementary device, not as a substitute for the 
conventional exhibits of the affairs of either the parent or the 
subsidiary corapanies, Th9 stool^holders and creditors of corpora- 
tion are immediately concerned with the statements of their 
companies as an independent organization, and only secondarily 
with the joint picture of the affiliated companies. The earnings 
of the subsidiary are not the earnings of the parent and the 
assets of the subsidiary are not available to meet claims of 
creditors of the parent. This means that the practice followed 
by most large companies of publishing no statements other than 
the combined reports is iinf ortunate , 

In the opinion of the writer the proper procedure in pres- 
entation of consolidated statements is to submit individual 
reports of all the companies in the affiliation. These reports 
should be substantiated by supporting details of the data used 
in their formulation. The consolidated v;orking papers and ex- 
hibits should provide for columns showing the parent company's 
position; another column or as many colizmns as needed for the 
individual subsidiaries; another column to show the combined 
position of parent and subsidiaries; another column for ad- 
justments and eliminations of intercompany transactions; and a 
final column to show the final total for the consolidation. This 
procedure would give a comprehensive picture of the financial 
and operating position of each individual company plus that of 


the affiliation. If, however, the subsidiary corapanies are, in 
effect, merely departments of the parent company and their 
operating oboective is only to facilitate the parent company 
operations, consolidated' statements may be sufficient providing 
that intercompany transactions and profits are properly elimi- 

All intercompany transactions must be eliminated in order 
to show the affiliated companies as one operation. This affects 
the income statement by removing all intercompany nominal accounts 
and recognizes only transactions that were negotiated with out- 
siders during the period. The intercompany nominal accounts are 
reciprocal on the ledgers of the two affiliated companies; there- 
fore one companjA has recorded an income, and an affiliate company 
has recorded the e>rpense . If these reciprocal accounts were not 
eliminated, this would not affect the consolidated profit. This 
is because the income of one company would automatically be off- 
set by the e:cpense of the affiliated company. The only purpose 
for eliminating these accounts is to shov/, in the consolidated 
statements, only those transactions that have been entered into 
with outsiders; therefore, those transactions which appear to 
be conducted within the group of related companies must be 
eliminated. The unrealized profit remaining in the ending inven- 
■cory of the vendee company, which arose through intercompany 
transactions, must also be eliminated in order to show only the 
profit realized through the sale to outsiders or to companies 

ot affiliated with the group. Profit shown to have been real- 
ized on the sales of intercompany fixed assets must also be 



elininated. This is so because the affiliation cannot realize 
a -oroiit on soaethinp; that in fact sold to itself. 

The effect of removing unrealized intercompany profits on 
the consolidated income statement is to shov- the net income 
re^alized only from transactions with outsiders. The removal of 
unrealized profits will tend to show a total consolidated profit 
of a lesser aiiiount than merely the sum of the net income shown 
oh each company's ledger before consolidation. Therefore, by 
removing unrealized profits and eliminating the intercompany 
nominal accounts from the consolidated income statement, the 
objectives of consolido.Gxon are accomplished. Consolidated net 
income reflects only amoumts realized through transactions with 
outsiders. The several companies are reflected as a single 
entity operation and tnus offer the needed information requested 
by management and stockholders of the parent or dominant company. 



The writer is indebted to Professor \V. J. Clark, C.P.A. 
and Assistant Professor W. D. Tuxbury, C.P.A. for their sincere 
interest and encouragement in writing this report. 




Faton, Y/illian A. Advanced Accountirij?: . New York: Hacraillan 
Company, 19'4-1. 

RaiToaTDort, Louis H.- S.E.C. Accounting practice and Procedure. 
New York: Ronald Press Gorapany, I'^'pb. 

V.'ixon, Rufus. Accountant's Handbook . Fourth edition. Nev; York: 
Ronald Press Company, 19^2. 

Journals , i-'lomographs and Bulletins 

American .Accounting- Association. Accounting and Reporting 

Standards xor ^ Cor-Qorate Financi al Stateiaen'i:s ^nd Preceding 
Statei:\ents and Sur>oieiaent¥ T MaoTson Wisconsin: University 
of 'Wisconsin, 19^7 • 

Alford, Edwin D. "Mutual StockhxOldings in Consolidated State- 
ments." The Journal of Accountancy , Oct. 1959. 

Blou&:h, Carmen G. Practical Applications of Accounting Standards . 
"Boston: AICPa, 19b7. 

Brundage, Fercival P. "Some Shortcomings in Consolidated State- 
ments." 'The Journal of Accountancy , Oct. 1950. 

Committee on Accounting Procedure. "Consolidated Financial 
Statements." The Journal of Accountancy , Oct. 19:?9. 

Committee on Accounting Procedure. Accounting Research Bulle - 
tin No. 51, New York: AICPA, iWT- " 

Committee on Accounting Procedure. Acco\mting Research and Term - 
inology Bulletins . Final edition. New York: AlCrA,' 1961. 

Committee on Concepts and Standards, American Accounting Associa- 
tion. "Consolidated Financial Statements." The .Accounting 
Review , April 1955. 

Erp, E. J. "Preparing Consolidated Statements for Management." 
Controller , Aug. 1955. 

Holt, '.'.'alter A. "Accounting Problems of Mergers and Consoli- 
dations." N.A.C.A. Bulletin , June 1956. 

Jensen, Y/allace IvI. "Tax Clinic." The Journal of Accountancy , 
March 1963. 


Kracke, Sdv/ard A. "Consolidated Financial Statements." The, 
Journal of Accountancy , Dec. 1933. 

Moonitz, Maurice. "Entity Approach to Consolidated Statements." 
■The AccQ-anting Review , July 19'^2. 

peoples, Jolin. "preparation of Consolidated Statements..." 
The Journal of Accountancy , Aug. 1957 • 

Research Department. alCPA "Survey of Consolidated Financial 
Stateraent Practices." New lork: 1956. 

Research Department, AlCPA . "Some Problems Regarding Consoli- 
dated and Parent Company Statements." The Journal of 
Accountancy , Nov. 1955. 

Sanders, Thomas H. , H. R. Hatfield, and U. Moore. " Statement 
of Accounting principles ." Columbus Ohio: AAA., 1933. 

Simon, Sidney I. "Consolidated^Statements and The Law." The 
Accounting Review , Oct. 19:?3. 

Special Supplement, The Revenue Act of 1962 , New Jersey: 
Prentice-Hall, 1962. 

Stempf , Victor H. "Consolidated Financial Statements." The 
Journal of Accountancy , Nov. 1936. 

inthjrcompany transactions in relation 
to consolidated income statements 


B. A., Adams State College, 1958 


submitted in partial fulfillment of the 

requirements for the degree 

School of Commerce 

Manhattan, Kansas 


Approved by: 

Major Professor 


The purpose of this report is to consider intercompany 
transactions in relation .to consolidated income statements as 
one subject matter area and to report on the methods for their 
elimination. The consolidated statements will reflect trans- 
actions of. the consolidated group with outsiders or third 
parties. The premise underlying consolidated statements is 
that the group in the consolidation will be represented as if 
it were one individual unit. To arrive at this objective all 
intercompany transactions are eliminated and a picture of the 
group is presented in relation to outsiders. 

The intercompany transactions and eliminations discussed 
in this report are the f ollovv'ing: 

1. Intercompany Interest, Rent, Fees, Bonds, etc. 

2. Intercompany Bad Debts. 

3. Intercompany Sales of Assets. 

4. Intercompany Sales of Merchandise. 

5. Intercompany Sales of Fixed Assets. 
5. Intercompany Dividends. 

7. i.iinority Interest in Earnings. 

With the elimination of intercompany transactions the -con- 
solidated statements reflect the several companies as a single 
entity and thus offers the needed information requested by 
management and stockholders of the parent or dominant company. 

The following general principles should be kept in mind 

whenever der.ling v/ith consolidated statements: 

1. Consolidated statements should be prepared for use 
of management, investors and other interested groups. 

2. Consolidated statements are never a satisfactory 
substitute for individual reports of parent and subsid- 
iaries. They should be viev/ed as a supplement to the 
regular reports. 

5. Relationships shown by consolidated statements 

should not be used to reflect the financial position of 

individual compajiies. 

"/hen control is exercised over subsidiaries by a parent 
company, it is desirable to show these companies not as legal 
entities, but as if they v/ere operating as one entity. This is 
accomplished by consolidating the financial activities of these 
companies into one set of statements. The consolidated state- 
ments will reflect the activities as if it were one and only 
one economic entity. , ••